Financial statement analysis

 Traditionally and popularly, in India the term ‘Financial

Statement’ means Balance Sheet and Profit & Loss Account.
However, the term ‘Financial Statement’ is formally defined as a
statement that contains financial information.

 It does not merely consist of Annual Report although presently

for the external users the major portion of financial information
comes from the Annual Report.

Objectives of Analysis:
Objectives will vary depending on the :

• perspective of the financial statement user

• specific questions that are addressed by the analysis

The identity of the user helps define what information is needed.

Objectives of Analysis Creditors:

A creditor is ultimately concerned with the ability of an existing or

prospective borrower to make interest and principal payments on borrowed
funds.

Objectives of Analysis Investors:

The investment analyst poses questions such as:

 What is the company’s performance record?

 What are the future expectations?
 How much risk is inherent in the existing capital structure?
 What are expected returns?
 What is firm’s competitive position?

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Objectives for Analysis Management:

Management relates to all questions raised by creditors and investors.

Management must also consider its employees, the general public,

regulators, and the financial press.

Objectives of Analysis Management:

Looks to financial statement data to determine:

 How well has the firm performed and why?

 What operating areas have contributed to success and which have
not?
 What are strengths and weaknesses of the company’s financial
position?
 What changes should be implemented to improve future
performance?

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Sources of Information:
Financial statement user has access to a wide range of data sources.
Objective of analysis dictates the approach and resources used.
Beginning point should be financial statements and the notes

The analyst will want to consider the following resources:

• Proxy statement
• Auditor’s report
• Management discussion and analysis
• Supplementary schedules
• From 10-K and From 10-Q
• Other Sour

• Computerized databases:

• Enhance analytical process

• Provide time-saving features

• Computerized financial statement analysis packages:

• Perform ratio calculations

• Other analytical tools

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 It is important to review the annual reports of suppliers, customers,
and competitors.
Many internet sites charge subscription fees to access information,
but public and university libraries often subscribe, making this
information free to the public.

What is common size analysis?

 Converting income statement and balance sheet values into %

to facilitate comparison between firms of different sizes and
firms over time.
 Income statement: Divide by sales.
 Balance sheet: Divide by total assets.
 Used to supplement ratio analysis.

Readers of Financial Analysis:

Determine the risk of the business defaulting on its

Lenders
loan

Managers Compare actual and budgeted results

Government Ensure that taxes have been paid

Suppliers Evaluate the company’s ability to pay its obligations

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Investment Analysts Evaluate the company’s performance

Highlight financial strengths, upside potential, and

Mergers and Acquisitions
future value

Management Reports:

 Daily Revenue Report

 Daily Payroll Cost Report
 Rooms Revenue Forecast
 Food and Beverage Menu Abstract
 Accounts Receivable Aging Schedule

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Types of Analysis
 Vertical Analysis
 Used to analyze variable expenses
 All accounts are sized using either:
 Total revenue or
 Departmental revenue
 Variable expenses should increase or decrease with the level of sales

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Parties demanding financial information :

 Shareholders, Investors and Security Analysts

 Managers.
 Employees.
 Lenders and Other Suppliers.
 Customers.
 Government/Regulatory Agencies.
 Others

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Balance Sheet :

 A balance sheet, sometimes called a “Statement of financial

position” or a “Statement of affaires” is a statement of financial
position of an enterprise on a particular date.
 The balance sheet is a snapshot of the firm’s assets and
liabilities at a given point in time
 Assets are listed in order of liquidity
 Ease of conversion to cash
 Without significant loss of value
 Balance Sheet Identity
 Assets = Liabilities + Stockholders’ Equity

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 The Balance Sheet format

Balance Sheet

As at 1-Mar-2011

Liabilities Assets
Capital Account 495000
Capital A/c 500000 FixedAsset 15000
Drawing A/c 5000 Furniture A/c 15000
Loans(Liability) 50000 Working Capital 599698
M/S Ashok
Deshpande 50000 Current Assets
Profit & Loss A/c 69698 Closing Stock 176540
Opening Balance Sundry Debtors 55000
Current Period 69698 Cash-in-hand 356958
Bank Accounts 201200
789698
less: Current
Liabilities
Sundry Creditor 190000

Total 614698 Total 614698

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Balance Sheet Analysis:

 When analyzing a balance sheet, the financial manager should be

aware of three concerns:
 Accounting liquidity
 Debt versus equity
 Value versus cost

Income statement:

1. The income statement which is also known as The Profit & Loss
Account is a statement of profit earned or loss incurred during the
accounting year.
2. Income statement is prepared on an accrual basis
3. Costs and revenues are recorded such that costs are tried to match
to corresponding revenues
4. Correct matching of costs and revenues is a difficult task
5. The problem of matching is especially relevant in the case of
depreciation charged for long-lived assets

Income statement format:

The income statement can be stated in two different formats :

 “T” Account Format.

 The vertical Format.

“t” Account format:

 The income statement, when stated in “T” account format it is

divided into number of sections or parts.

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  The end result of the first section serves as the starting point of
next section.

“T ” Account Format

Profit & Loss A/c

For year ended on 31-Mar-2011
Particulars Particulars
Opening Stock Sales Account 115000
Purchase
Accounts 202300 Sales A/c 115000
Purchase A/c 202300 Closing Stock 176540
Gross Profit c/o 89240 Closing Stock 176540
291540
291540
Indirect Expenses 19542
Gross Profit
Accounting Charges 300 b/f 89240
Carting Charges 500
Electricity Bill A/c 1042
Mobile Bill A/c 1500
Rent A/c 9000
Salary A/c 2000
Shop Expense 1500
Travelling Charges 1000

Nett Profit 69698

Total 89240 Total 89240

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 The vertical format

Following are the items of vertical format :

 Net sales refers to revenues that the firm has generated by selling its
products or services
 Costs of goods sold referes to material costs, administrative costs
etc. that are needed to produce the products of the firm
 Depreciations refers to the part of the long-lived assets such as
machines or buildings that is allocated to the given fiscal year
 Financial expenses refers to interest payment and other costs of the
debt capital of the firm
 Financial income refers to interest income and other incomes from
the financial assets of the firms

Basic structure of vartical format:

Net sales Cost of goods sold

= Operating income (EBITDA) Depreciations
= Earnings before interest and taxes (EBIT) Financial expenses and
income
= Earnings before tax Taxes
= Net income

Good to Know!!

EBITDA (Earnings before interest, taxes, depreciation and amortization

To measure cash earnings without accrual accounting, cancelling tax
jurisdiction effects, and cancelling the effects of different capital structures.

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Statement of Cash Flows

The Statement of Cash Flows reports:

 Operating activities
 Investing activities
 Financing activities

Cash flow from operating activities:

Net income $ 44,220

Additions (sources of cash):
Depreciation 20,000
Incr. in accruals 4,000
Incr. in accounts payable 29,600
Subtractions (uses of cash):
Incr. in receivables (50,800)
Incr. in inventories ( 120,800)
NCF from operations ($ 73,780)

Cash flow from investing activities:

Investment in fixed assets ($ 36,000)

Cash flow from financing activities:

Increase in notes payable $ 25,000

Increase in L-T debt 101,180
Common dividends ( 22,000)
NCF from financing $104,180
Net increase (decr.) in cash ($ 5,600)

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Cash at beginning of year 57,600
Cash at end of year $ 52,000

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 Definition of Financial Ratio

 It is a ratio of two selected numerical values taken from an

enterprise's financial statements.
 It is also called accounting ratio.

Objectives of Ratio Analysis:

 Standardize financial information for comparisons

 Evaluate current operations
 Compare performance with past performance
 Compare performance against other firms or industry standards
 Study the efficiency of operations
 Study the risk of operations

Definition of Financial Ratio Analysis:

 It is defined as the systematic use of ratio to interpret the financial

statements so that the strengths and weaknesses of a firm as well as
its historical performance and current financial condition can be
determined.
 Thus, ratio analysis is a widely used tool of financial analysis.
 Ratios make the related information comparable. A single figure by
itself has no meaning but when expressed in terms of related figure, it

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 yields significant inferences. Thus, ratios are relative figures reflecting
the relationship between related variables.

Types of Comparisons:-

Three types of comparisons are generally involved:

 Trend analysis.
 Inter-firm comparisons.
 Comparison with standards/industry average.

Trend analysis:

Trend ratios involve comparison of ratios of a firm over a period of time i.e.
present ratios are compared with past ratios for the same firm. Trend ratios
indicate the direction of change in the performance: improvement,
deterioration or constancy over the years.

Inter-firm comparisons:

Inter-firm comparison involves comparing the ratios of a firm with those of

others in the same line of business or for the industry as a whole. Thus, it
reflects the firm’s performance in relation to it’s competitors.

Comparison with standards/ industry average:

Other types of comparisons may relate to the comparison of items within a

single year’s financial statement of a firm and comparison with standards or
plan. Figures provided by trading and profit and loss account and balance
sheet are not self explanatory in nature. Figures to arrive at certain
conclusions, for example, figure of net profit can be compared with total
sales or total capital employed by the company and it can also be
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compared with figures of other company and profitability can be judged
properly.

RATIO ANALYSIS:

It refers to the systematic use of ratios to interpret the financial statements

in terms of the operating performance and financial position of a firm. It
involves comparison for a meaningful interpretation of the financial
statements.

In view of the needs of various uses of ratios the ratios, which can be
calculated from the accounting data are classified into the following broad
categories

Types of Ratios:-

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Ratios can broadly be classified into four groups:

 Liquidity ratios
 Capital structure/leverage ratios
 Profitability ratios
 Activity/turnover/efficiency ratio

A. LIQUIDITY RATIO

It measures the ability of the firm to meet its short-term obligations, that is
capacity of the firm to pay its current liabilities as and when they fall due.
Thus these ratios reflect the short-term financial solvency of a firm. A firm
should ensure that it does not suffer from lack of liquidity. The failure to
meet obligations on due time may result in bad credit image, loss of
creditors confidence, and even in legal proceedings against the firm on the
other hand very high degree of liquidity is also not desirable since it would
imply that funds are idle and earn nothing. So therefore it is necessary to
strike a proper balance between liquidity and lack of liquidity.

The various ratios that explains about the liquidity of the firm are

1. Current Ratio
2. Acid Test Ratio / quick ratio
3. Absolute liquid ration / cash ratio

 Current ratio:

ratio of total current assets to total current liabilities. A satisfactory

current ratio will enable a firm to meet it’s obligations even if the value
of the current assets declines. It is however a quantitative index of
liquidity as it does not differentiate between the components of
current assets, such as cash and inventory that are not equally liquid.

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  Quick or acid test ratio:

takes into consideration the different liquidity of the components of

current assets. It represents the ratio between quick current assets
and the total current liabilities. It is a rigorous measure and superior
to the current ratio. However, both these ratios should be used to
analyze the liquidity of a firm.

1.CURRENT RATIO:
The current ratio measures the short-term solvency of the firm. It
establishes the relationship between current assets and current liabilities.
It is calculated by dividing current assets by current liabilities.

Current Ratio = Current Asset

Current Liabilities

Current assets include cash and bank balances, marketable securities,

inventory, and debtors, excluding provisions for bad debts and doubtful
debtors, bills receivables and prepaid expenses. Current liabilities includes
sundry creditors, bills payable, short- term loans, income-tax liability,
accrued expenses and dividends payable.

2.5

2
Current Ratio

1.5

0.5

0
Jan-96 Jan-97 Jan-98 Jan-99 Jan-00
Dell 2.08 1.66 1.45 1.72 1.48
Industry 1.80 1.80 1.90 1.60

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1.ACID TEST RATIO / QUICK RATIO:

It has been an important indicator of the firm’s liquidity position and is used
as a complementary ratio to the current ratio. It establishes the relationship
between quick assets and current liabilities. It is calculated by dividing
quick assets by the current liabilities.

Acid Test Ratio = Quick Assets

Current liabilities

Quick assets are those current assets, which can be converted into cash
immediately or within reasonable short time without a loss of value. These
include cash and bank balances, sundry debtors, bill’s receivables and
short-term marketable securities.

3. ABSOLUTE LIQUID RATION / CASH RATIO:

It shows the relationship between absolute liquid or super quick current

assets and liabilities. Absolute liquid assets include cash, bank balances,
and marketable securities.

Absolute liquid ratio = Absolute liquid assets

Current liabilities

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B. TURNOVER RATIO

Activity/turnover/efficiency ratios:

Activity ratios are also known as efficiency or turnover ratios. Such ratios
are concerned with measuring the efficiency in asset management. The
efficiency with which assets are managed/used is reflected in the speed
and rapidity with which they are converted into sales. Thus, the activity
ratios are a test of relationship between sales/cost of goods sold and
assets. Depending upon the type of asset, activity ratios may be:

Inventory/stock turnover ratio:

It indicates the number of times inventory is replaced during the year, of

how quickly the goods are sold. It is a test of efficiency of inventory
management.

Receivables/debtors turnover:

It is indicative of the efficiency of receivables management as it shows

how quickly trade goods are sold.

Total assets turnover:

It shows the efficiency in managing and utilizing the total assets.

Turnover ratios are also known as activity ratios or efficiency ratios with
which a firm manages its current assets. The following turnover ratios can
be calculated to judge the effectiveness of asset use.

 Inventory Turnover Ratio

 Debtor Turnover Ratio
 Creditor Turnover Ratio

 Assets Turnover Ratio

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INVENTORY TURNOVER RATIO:

This ratio indicates the number of times the inventory has been converted
into sales during the period. Thus it evaluates the efficiency of the firm in
managing its inventory. It is calculated by dividing the cost of goods sold
by average inventory.

Inventory Turnover Ratio = Cost of goods sold

Average Inventory

The average inventory is simple average of the opening and closing

balances of inventory. (Opening + Closing balances / 2). In certain
circumstances opening balance of the inventory may not be known then
closing balance of inventory may be considered as average inventory

1. DEBTOR TURNOVER RATIO:

This indicates the number of times average debtors have been converted
into cash during a year. It is determined by dividing the net credit sales by
average debtors.

Debtor Turnover Ratio = Net Credit Sales

Average Trade Debtors

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Net credit sales consist of gross credit sales minus sales return. Trade
debtor includes sundry debtors and bill’s receivables. Average trade
debtors (Opening + Closing balances / 2)

When the information about credit sales, opening and closing balances of
trade debtors is not available then the ratio can be calculated by dividing
total sales by closing balances of trade debtor

Debtor Turnover Ratio = Total Sales

Trade Debtors

2.CREDITOR TURNOVER RATIO:

It indicates the number of times sundry creditors have been paid during a
year. It is calculated to judge the requirements of cash for paying sundry
creditors. It is calculated by dividing the net credit purchases by average
creditors.

Creditor Turnover Ratio = Net Credit Purchases

Average Trade Credit

Net credit purchases consist of gross credit purchases minus purchase

return

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When the information about credit purchases, opening and closing
balances of trade creditors is not available then the ratio is calculated by
dividing total purchases by the closing balance of trade creditors.

Creditor Turnover Ratio = Total purchases

Total Trade Creditors

2. ASSETS TURNOVER RATIO:

The relationship between assets and sales is known as assets turnover

ratio. Several assets turnover ratios can be calculated depending upon the
groups of assets, which are related to sales.

a) Total asset turnover.

b) Net asset turnover
c) Fixed asset turnover
d) Current asset turnover
e) Net working capital turnover ratio

a. TOTAL ASSET TURNOVER:

This ratio shows the firm’s ability to generate sales from all financial
resources committed to total assets. It is calculated by dividing sales by
total assets.

Total asset turnover = Total Sales

Total Assets

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b. NET ASSET TURNOVER:

This is calculated by dividing sales by net assets.

Net asset turnover = Total Sales

Net Assets

Net assets represent total assets minus current liabilities. Intangible and
fictitious assets like goodwill, patents, accumulated losses, deferred
expenditure may be excluded for calculating the net asset turnover.

c. FIXED ASSET TURNOVER

This ratio is calculated by dividing sales by net fixed assets.

Fixed asset turnover = Total Sales

Net Fixed Assets

Net fixed assets represent the cost of fixed assets minus depreciation.

d. CURRENT ASSET TURNOVER:

It is divided by calculating sales by current assets

Current asset turnover = Total Sales

Current Assets

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e. NET WORKING CAPITAL TURNOVER RATIO:

A higher ratio is an indicator of better utilization of current assets and

working capital and vice-versa (a lower ratio is an indicator of poor
utilization of current assets and working capital). It is calculated by dividing
sales by working capital.

Net working capital turnover ratio = Total Sales

Working capital

Working capital is represented by the difference between current assets

and current liabilities.

C. SOLVENCY OR LEVERAGE RATIOS

Capital Structure/Leverage Ratios:

These ratios throw light on long-term solvency of a firm. This is reflected in

its ability to assure the long term creditors with regard to periodic payment
of interest and the repayment of a loan on maturity or predetermined
installments at due dates. There are two types of such ratios:

Debt-equity or debt-assets ratio:

It is computed from the balance sheet and reflects the relative

contribution/stake of owners and creditors in financing the assets of the
firm. In other words, such ratios reflect the safety margin to the long term
creditors.

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 Coverage ratio:

These ratios are based on the income statement and show the number
of times the fixed obligations are covered by earnings before interest
and taxes. They indicate the extent to which a fall in operating profits is
tolerable in that the ability to repay will not be adversely affected.

The solvency or leverage ratios throws light on the long term solvency of a
firm reflecting its ability to assure the long term creditors with regard to
periodic payment of interest during the period and loan repayment of
principal on maturity or in predetermined installments at due dates. There
are thus two aspects of the long-term solvency of a firm.

a. Ability to repay the principal amount when due

b. Regular payment of the interest.

The ratio is based on the relationship between borrowed funds and owner’s
capital it is computed from the balance sheet, the second type is calculated
from the profit and loss a/c. The various solvency ratios are:

1. Debt equity ratio

2. Debt to total capital ratio
3. Proprietary (Equity) ratio
4. Fixed assets to net worth ratio
5. Fixed assets to long term funds ratio
6. Debt service (Interest coverage) ratio

1. DEBT EQUITY RATIO:

Debt equity ratio shows the relative claims of creditors (Outsiders) and
owners (Interest) against the assets of the firm. Thus this ratio indicates
the relative proportions of debt and equity in financing the firm’s assets. It

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can be calculated by dividing outsider funds (Debt) by shareholder funds
(Equity)

Debt equity ratio = Outsider Funds (Total Debts)

Shareholder Funds or Equity

The outsider fund includes long-term debts as well as current liabilities.

The shareholder funds include equity share capital, preference share
capital, reserves and surplus including accumulated profits. However
fictitious assets like accumulated deferred expenses etc should be
deducted from the total of these items to shareholder funds. The
shareholder funds so calculated are known as net worth of the business.

0.8
Debt Ratio

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
Jan-96 Jan-97 Jan-98 Jan-99 Jan-00
Dell 54.70% 73.07% 69.70% 66.25% 53.73%
Industry 62.96% 60.00% 52.38% 62.96%

2. DEBT TO TOTAL CAPITAL RATIO:

Debt to total capital ratio = Total Debts

Total Assets

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3. PROPRIETARY (EQUITY) RATIO:

This ratio indicates the proportion of total assets financed by owners. It is

calculated by dividing proprietor (Shareholder) funds by total assets.

Proprietary (equity) ratio = Shareholder funds

Total assets

4. FIXED ASSETS TO NET WORTH RATIO:

This ratio establishes the relationship between fixed assets and

shareholder funds. It is calculated by dividing fixed assets by shareholder
funds.

Fixed assets to net worth ratio = Fixed Assets X 100

Net Worth

The shareholder funds include equity share capital, preference share

capital, reserves and surplus including accumulated profits. However
fictitious assets like accumulated deferred expenses etc should be
deducted from the total of these items to shareholder funds. The
shareholder funds so calculated are known as net worth of the business.

4. FIXED ASSETS TO LONG TERM FUNDS RATIO:

Fixed assets to long term funds ratio establishes the relationship between
fixed assets and long-term funds and is calculated by dividing fixed assets
by long term funds.
Fixed assets to long term funds ratio = Fixed Assets X 100

Long-term Funds

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5. DEBT SERVICE (INTEREST COVERAGE) RATIO:

This shows the number of times the earnings of the firms are able to cover
the fixed interest liability of the firm. This ratio therefore is also known as
Interest coverage or time interest earned ratio. It is calculated by dividing
the earnings before interest and tax (EBIT) by interest charges on loans.

Debt Service Ratio = Earnings before interest and tax (EBIT)

Interest Charges

D. PROFITABILITY RATIOS

The profitability of a firm can be measured by the profitability ratios. Such

ratios can be computed either from sales or investments. The profitability
ratios based on sales are:

 Profit margin (gross and net).

 Expenses/ operating ratios.

They indicate the proportion of sales consumed by operating costs and the
proportion available to meet financial and other expenses.

The profitability ratios related to investments include:

 Return on assets.
 Return on shareholders’ equity including earning per share, dividend
per share, dividend-payout ratio, earning and dividend yield.

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The overall profitability (earning power) is measured by the return on
investment which is computed as a combined product of net profit margin
and investment turnover. It is central measure of the earning power and
operating efficiency of a firm.

The profitability ratio of the firm can be measured by calculating various

profitability ratios. General two groups of profitability ratios are calculated.

a) Profitability in relation to sales.

b) Profitability in relation to investments.

Profitability in relation to sales:

1. Gross profit margin or ratio

2. Net profit margin or ratio
3. Operating profit margin or ratio
4. Operating Ratio
5. Expenses Ratio

1. GROSS PROFIT MARGIN OR RATIO:

It measures the relationship between gross profit and sales. It is calculated

by dividing gross profit by sales.

Gross profit margin or ratio = Gross profit X 100

Net sales

Gross profit is the difference between sales and cost of goods sold.

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 2. NET PROFIT MARGIN OR RATIO:

It measures the relationship between net profit and sales of a firm. It

indicates management’s efficiency in manufacturing, administrating, and
selling the products. It is calculated by dividing net profit after tax by sales.

Net profit margin or ratio = Earnings after tax X 100

Net Sales

3. OPERATING PROFIT MARGIN OR RATIO:

It establishes the relationship between total operating expenses and net

sales. It is calculated by dividing operating expenses by the net sales.

Operating profit margin or ratio = Operating expenses X 100

Net sales

Operating expenses includes cost of goods produced/sold, general and

administrative expenses, selling and distributive expenses.

3. EXPENSES RATIO:

While some of the expenses may be increasing and other may be declining
to know the behavior of specific items of expenses the ratio of each
individual operating expense to net sales should be calculated. The
various variants of expenses are

Cost of goods sold = Cost of goods sold X 100

Net Sales
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Administrative Expenses Ratio = Administrative Expenses X 100

Net sales

Selling and distribution expenses ratio = Selling and distribution

expenses X 100 Net sales

6. OPERATING PROFIT MARGIN OR RATIO:

Operating profit margin or ratio establishes the relationship between

operating profit and net sales. It is calculated by dividing operating profit by
sales.

Operating profit margin or ratio = Operating Profit X 100

Net sales

Operating profit is the difference between net sales and total operating
expenses. (Operating profit = Net sales – cost of goods sold –
administrative expenses – selling and distribution expenses.)

PROFITABILITY IN RELATION TO INVESTMENTS:

1. Return on gross investment or gross capital employed

2. Return on net investment or net capital employed
3. Return on shareholder’s investment or shareholder’s capital employed.
4. Return on equity shareholder investment or equity shareholder capital
employed.

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1. RETURN ON GROSS CAPITAL EMPLOYED:

This ratio establishes the relationship between net profit and the gross
capital employed. The term gross capital employed refers to the total
investment made in business. The conventional approach is to divide
Earnings after Tax (EAT) by gross capital employed.

Return on gross capital employed = Earnings after Tax (EAT) X

100*Gross capital employed

2. RETURN ON NET CAPITAL EMPLOYED:

It is calculated by dividing Earnings before Interest & Tax (EBIT) by the net
capital employed. The term net capital employed in the gross capital in the
business less current liabilities. Thus it represents the long-term funds
supplied by creditors and owners of the firm.

Return on net capital employed = Earnings Before Interest & Tax

(EBIT) X 100 Net capital employed

3. RETURN ON SHARE CAPITAL EMPLOYED:

This ratio establishes the relationship between earnings after taxes and the
shareholder investment in the business. This ratio reveals how profitability
the owners’ funds have been utilized by the firm. It is calculated by dividing
Earnings after tax (EAT) by shareholder capital employed.

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Return on share capital employed = Earnings after tax (EAT) X 100
Shareholder capital employed

4. RETURN ON EQUITY SHARE CAPITAL EMPLOYED:

Equity shareholders are entitled to all the profits remaining after the all
outside claims including dividends on preference share capital are paid in
full. The earnings may be distributed to them or retained in the business.
Return on equity share capital investments or capital employed establishes
the relationship between earnings after tax and preference dividend and
equity shareholder investment or capital employed or net worth. It is
calculated by dividing earnings after tax and preference dividend by equity
shareholder’s capital employed.

Return on equity share capital employed = Earnings after tax (EAT),

preference dividends X 100 /Equity share capital employed

EARNINGS PER SHARE:

IT measure the profit available to the equity shareholders on a per share

basis. It is computed by dividing earnings available to the equity
shareholders by the total number of equity share outstanding

Earnings per share = Earnings after tax – Preferred dividends (if

any)Equity shares outstanding

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DIVIDEND PER SHARE:

The dividends paid to the shareholders on a per share basis in dividend per
share. Thus dividend per share is the earnings distributed to the ordinary
shareholders divided by the number of ordinary shares outstanding.

Dividend per share = Earnings paid to the ordinary shareholders

Number of ordinary shares outstanding

DIVIDENDS PAY OUT RATIO (PAY OUT RATIO):

It measures the relationship between the earnings belonging to the equity

shareholders and the dividends paid to them. It shows what percentage
shares of the earnings are available for the ordinary shareholders are paid
out as dividend to the ordinary shareholders. It can be calculated by
dividing the total dividend paid to the equity shareholders by the total
earnings available to them or alternatively by dividing dividend per share by
earnings per share.

Dividend pay our ratio (Pay our ratio) = Total dividend paid to equity
share holders /Total earnings available to equity share holders

Or Earnings per share

Dividend per share:

DIVIDEND AND EARNINGS YIELD:

While the earnings per share and dividend per share are based on the
book value per share, the yield is expressed in terms of market value per
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share. The dividend yield may be defined as the relation of dividend per
share to the market value per ordinary share and the earning ratio as the
ratio of earnings per share to the market value of ordinary share.

Dividend Yield = Dividend Per share

Market value of ordinary share

Earnings yield = Earnings per share

Market value of ordinary share

PRICE EARNING RATIO:

The reciprocal of the earnings yield is called price earnings ratio. It is

calculated by dividing the market price of the share by the earnings per
share.

Price earnings (P/E) ratio = Market price of share

Earnings per share

Advantages of Financial Ratios and Ratio Analysis:

 They make it more convenient to estimate to other figures when one

figure is known.
 Investment decisions are based on ratio analysis.
 They act as an index or parameter of efficiency of the
firm/organization.
 They are one type of tool of management.
 They amplify many complicated financial statements.
 They highlight the weaknesses of the enterprise.
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  They provide more analytical information to the management for
decision making and controlling purpose.

Limitations of Financial Ratios and Ratio Analysis

 Reliability of ratios depends upon the reliability of the original

data/information collected.
 Increases, decreases and constant changes in the prices distort the
comparison over period of years.
 The benefits of a ratio analysis depend on correct interpretation.
Many times it is observed that due to small errors in original data it
leads to false conclusions.
 Ratio analysis is not an ultimate yardstick for assessing the
performance of a firm.
 If there is window dressing, then the ratios calculated will fail to give
the correct picture and it will be mis-management.

………

Du Pont identity:
According to the Dupont Identity, Return on equity (ROE) can be
decomposed as follows:
Net earnings
Return on equity 
Equity
Net earnings Assets
 
Assets Equity
Net earnings Sales Assets
  
Sales Assets Equity

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Du Pont Equation Provides an Overview
 Profitability measured by ROE
 Expense control measured by PM
 Asset utilization measured by TATO
 Financial leverage measured by EM (debt utilization)
 The interaction between the determinants of ROE

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Recommendation of Financial Ratios

 Ratios help to:

– Evaluate performance

– Structure analysis

– Show the connection between activities and performance

 Benchmark with

– Past for the company

– Industry

 Ratios adjust for size differences

Management Decision Making:

Employee Scheduling:

Based on:

 Accurate revenue forecasts

 Productivity goals
 Customer service goals

 Food and Beverage Pricing

 Track sales of each menu item
 Calculate each items gross profitability
 Set menu prices
 Remove unprofitable items from the menu

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 Revenue Management
 Goal is to maximize RevPAR
 Rev Par= Rooms Revenue/Rooms Available
 Strategies
 Close lower levels of pricing during high demand
 Open all pricing levels during times of low demand

 Profit Flexing
 Utilized when revenues fall behind budget
 Adjust pricing and reduce expenses
 Without impacting customer service
 Maximize remaining revenue opportunities.

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